Inflation Under Fixed and Flexible Exchange Rates
  • 1 0000000404811396https://isni.org/isni/0000000404811396International Monetary Fund
  • | 2 0000000404811396https://isni.org/isni/0000000404811396International Monetary Fund

This paper is concerned with the generation, transmission, and control of inflation under, alternatively, fixed and floating exchange rate regimes. More specifically, its primary purpose is to set out and to evaluate the main arguments that have been advanced to support the proposition that flexible exchange rates are more (less) inflationary than fixed exchange rates.

Abstract

This paper is concerned with the generation, transmission, and control of inflation under, alternatively, fixed and floating exchange rate regimes. More specifically, its primary purpose is to set out and to evaluate the main arguments that have been advanced to support the proposition that flexible exchange rates are more (less) inflationary than fixed exchange rates.

This paper is concerned with the generation, transmission, and control of inflation under, alternatively, fixed and floating exchange rate regimes. More specifically, its primary purpose is to set out and to evaluate the main arguments that have been advanced to support the proposition that flexible exchange rates are more (less) inflationary than fixed exchange rates.

The issue of the relative merits of fixed and flexible exchange rates, of course, is an old and much-discussed one. The classic contributions on the subject (e.g., Friedman (1953), Meade (1955), Caves (1963), and Johnson (1973)), however, were written before the recent experience with generalized floating, and most are concerned primarily with the role of the exchange rate regime in the adjustment process, rather than with its impact on inflation per se. In present circumstances, when high rates of inflation are coexisting with a more flexible exchange rate system than at any time since the 1930s, the interrelationship between these two phenomena takes on increased policy interest.

A second, and perhaps more fundamental, reason for re-examining this issue is that earlier writing on the subject has, in our view, often failed to draw certain distinctions about the different kinds of price effects that could be generated under one exchange rate system as compared with another. In particular, we think it important to distinguish between: (i) effects on a single country’s inflation rate and effects on the world inflation rate; (ii) effects on the mean rate of world inflation and effects on the dispersion of world inflation, either across countries or over time; and (iii) effects on the inflation rate that are, more or less, welfare neutral and those effects that are not. This is not to say that all arguments or hypotheses about inflation and exchange rate systems can be neatly placed or classified according to these distinctions, but rather to suggest that these distinctions may at least guard against some unnecessary ambiguity in the analysis.

At the outset, it should be stated that our concern in this paper is more with the impact of the exchange rate system on the generation of world inflation than on its role in the transmission of inflation from one country to another.1 We accept the widely held view that the nature of the exchange rate regime will have a significant impact on the way in which inflationary disturbances in any one country are shared throughout the constituent parts of the world economy. We refer here to the general property of flexible rates to “bottle up” inflationary disturbances in the country of origin vis-à-vis the “sharing” of inflation under fixed rates.2 Thus, it seems clear that the choice between fixed and flexible rates can, and undoubtedly will, have an effect on the actual rate of inflation experienced in individual countries. It is when one turns to the question of how the exchange rate regime affects the average level of world inflation that definite conclusions are more difficult to establish. Here, the fact that one exchange rate system tends to spread inflationary disturbances around, while another does not, becomes less important unless one has strong presumptions both about where the disturbances are most likely to originate and about how “sending” and “receiving” countries differ with regard to cyclical positions, structural characteristics, efficiency of stabilization policies, etc. In our view, such presumptions are difficult to justify and, for the purposes of this paper, we shall regard the more mechanical aspects of the transmission issue as being essentially neutral with respect to the world inflation rate.

The plan of the paper is as follows: Section I discusses possible systematic effects of a change in the exchange rate regime on the price level. More specifically, we examine the propositions that flexible exchange rates will increase the world price level both by increasing the costs of production (owing to the higher cost of foreign exchange insurance) and by reducing either the official or private (world) demand for money (which in turn is presumed to lead to an excess demand for goods). Factors affecting simply the level of prices do not, of course, have a lasting effect on inflation rates. But if the speed of adjustment to a new equilibrium price level is other than very rapid, then for the policymaker’s relevant time horizon, the consequences of these factors may be quite similar to those that lead to a change in the rate of inflation; for this reason, they are worth looking at. Section II considers various arguments as to how the exchange rate regime might affect inflation rates by affecting either governments’ policy preferences in the demand management area or the locus of attainable policy objectives 3 (as represented, say, by governments’ perceptions of their Phillips curves).4 In particular, attention is focused on the “reserve discipline” argument and on several “ratchet-effect” arguments—most of which are usually associated with support for fixed exchange rates. Finally, Section III attempts to pull together some conclusions and to consider some of the welfare implications of choosing one exchange regime rather than another on the basis of expected anti-inflationary behavior.

Before proceeding to the analysis itself, it is perhaps necessary to say a few words about how “fixed” and “flexible” exchange rates are to be interpreted in what follows. In much theoretical analysis where the purpose was to compare and contrast the properties of fixed and flexible rates, the usual practice has been to define or interpret fixed and flexible rates in their pure form (e.g., see Mundell (1961) and Kemp (1964)). That is, a fixed rate is defined as one where the authorities maintain the external value of their currency within a narrow margin of parity, and use means other than parity changes to adjust to external disequilibrium. In a similar vein, a flexible rate is often considered as one that is determined purely by supply and demand forces in the foreign exchange market, without any interference by the monetary authorities.

While a comparison of polar cases is possible at the theoretical level, and indeed useful in drawing out the implied differences between the two adjustment mechanisms, for the purpose of this paper it is not necessary to restrict so tightly the definitions of the two types of exchange rate system. In particular, it is not necessary to exclude the possibilities of limited government intervention in the foreign exchange market in the case of flexible rates, nor the alteration (albeit infrequent) of par values under fixed rates.

For our purposes, the distinction is that exchange rate movements are assumed to be more frequent under flexible than under fixed rates, and that more of the burden of balance of payments adjustment will be borne by exchange rate changes under flexible rates. In addition, we do not assume, for the most part, that either exchange rate system operates in a flawless manner. In other words the fixed rate system we have in mind is approximately the exchange rate regime operating during, say, the period 1958–70, and the flexible rate system is the one in operation since, say, the second quarter of 1973.

I. Effects of the Exchange Rate Regime on the Price Level

The exchange rate regime can have an effect on the (world) price level if it changes either the supply or demand for goods. Such price level effects should not, in themselves, have any continuing effect on the world inflation rate. However, insofar as any upward movement in these supply or demand curves is validated by government policies and repeated, it may well result in a longer-run shift in the rate of inflation. The question of whether governments’ policy responses will be systematically influenced by the exchange rate regime, however, is one that bears primarily on the rate of inflation and is therefore dealt with in Section II. This section begins by considering how an increase in exchange rate uncertainty might influence trade flows and the prices of tradable goods. It continues by analyzing possible effects of exchange rate uncertainty on the demand for liquidity (both official and private).

effects on the volume and prices of international trade

When exchange rates change in an unpredictable manner, both importers and exporters face uncertainty because they are not sure about the price they will have to pay or receive for foreign exchange. In the usual case where one or both parties are risk averse, and where it is possible to buy insurance against this exchange rate uncertainty (i.e., where forward exchange markets are developed for the relevant maturities), such insurance, or “hedging” costs, can simply be added to the costs of production and distribution, and it should be immaterial whether this protection is purchased by the buyer or seller.5 In either case, the result will be an increase in the price of the traded good. Where such insurance protection is not available, or where the importer chooses to self-insure rather than hedge all his transactions in the forward market, the effect of uncertainty on price is ambiguous, and depends, as Hooper and Kohlhagen (1976) have shown, on which party bears the risk. If importers bear the exchange risk (the usual case, according to Hooper and Kohlhagen), their demand for imported goods will fall and the price of internationally traded goods should decline. If, on the other hand, the exchange risk is borne by exporters, the price will rise as exporters add a risk premium to their other costs of production in arriving at a selling price. Where risks are shared, the effect on price depends on relative supply and demand elasticities. In all cases, increased uncertainty tends to reduce the volume of world trade (since a backward shift in either the supply or demand curve produces a fall in quantity). The more elastic is the import supply curve relative to the import demand curve, the greater will be the volume effects of increased uncertainty relative to the price effects. Finally, to the extent that a fall in the volume of international trade reduces international specialization in production and prompts a longer-term shift in production to higher-cost locations, it will tend to push up the world price level.

From the foregoing propositions comes the familiar argument that flexible exchange rates, by way of greater exchange rate uncertainty, will increase the world price level. While easy to grasp intuitively, this argument assumes that: (i) exchange rates will be more variable (and unpredictable) under flexible rates than under fixed rates, and (ii) exchange rate uncertainty captures all the relevant uncertainties faced by international traders so that the costs of uncertainty are greater under flexible than under fixed rates. Both of these assumptions need to be examined in somewhat more detail.

Friedman (1953), among many others, has pointed out that the freedom of exchange rates to move under flexible rates does not imply that they will in fact be unstable. Provided that underlying cost and demand conditions at home and abroad are reasonably stable, there is no reason to expect erratic shifts in either the supply of or demand for foreign exchange, and, thus, no need for erratic exchange rate movements. Speculation could, of course, generate fluctuations in rates, but most advocates of flexible rates assume that speculation, perhaps after an initial learning period, will be of the stabilizing rather than of the destabilizing variety, that is, it will push rates toward rather than away from their equilibrium position.6

Actual experience with floating exchange rates is still quite limited, so that it is far from clear how much exchange rate variability should be expected under floating rates, especially under reasonably orderly economic conditions. At the simplest level, it is clear that the advent of generalized floating has been associated with substantial volatility in bilateral exchange rates. Movements in spot exchange rates of as much as 20 per cent quarter to quarter, 5 per cent week to week, and 1 per cent hour to hour have not been unusual, despite the fact that such movements are large by historical standards. (See Hirsch and Higham (1974), McKinnon (1974), and Dooley and Shafer (1975).)

This evidence, however, taken by itself is probably a misleading guide to the amount of exchange rate variability attributable to floating per se. In the first place, as pointed out in IMF (1975, p. 27) “to assess the implications for trade flows of the exchange rate movements that have occurred, indices of effective exchange rates need to be employed”; and movements in effective exchange rates have been much less than bilateral exchange rate changes. For the deutsche mark, for example, quarter-to-quarter swings in its effective exchange rate have typically been only about half as large as swings in its market exchange rate against the dollar. Second, the underlying conditions (e.g., the oil price increase, the world-wide recession) during this period were quite disturbed, and most observers would concede that had a fixed rate system been in operation, substantial changes in parity would probably have been required. Finally, the period of floating inherited substantial payments disequilibria from the later years of the fixed rate period, and under these conditions it was to be expected that markets would take some time to find the new equilibrium pattern of exchange rates. Despite these caveats, however, the evidence with floating so far is consistent with the view that speculators do not typically have sufficient information or resources to smooth exchange rate fluctuations in the manner suggested by advocates of floating exchange rates.

If it is accepted that flexible rates generate somewhat greater exchange rate uncertainty than do fixed rates, it could still be argued that this type of uncertainty is no worse than the other types of uncertainty involved in trying to maintain a fixed pattern of rates. As Friedman (1953, p. 174) put it, “the substitution of flexible for rigid exchange rates changes the form in which uncertainty in the foreign exchange market is manifested; it may not change the extent of uncertainty at all and, indeed, may even decrease uncertainty.” Friedman is suggesting that failure to use the exchange rate as the equilibrating instrument in balance of payments adjustment implies that some other adjustment tool, be it aggregate demand policies, incomes policy, commercial policy, or exchange control, will have to bear more of the adjustment burden. These alternative methods of adjustment also create uncertainties for traders that in fact may be more damaging to trade, since exchange risk under floating is, at least in principle, the easiest to provide protection against by hedging in the futures market. Only if reserve changes were sufficient, by themselves, to finance balance of payments disturbances, without recourse to these other adjustment measures, could it be said that any reduction of uncertainty under fixed rates was not offset by an increase in other kinds of uncertainty for the private sector.

Makin (1974) has put forward a similar defense of flexible rates. He argues that exchange rate uncertainty may well be less under flexible rates because the private sector can predict the timing and size of exchange rate changes better when the inputs for the prediction are market forces rather than guesses about political judgments. However, on the other side, Williamson (1974) has argued that a credible par value may provide a stabilizing focus for exchange market traders and thereby reduce uncertainty relative to a system where there is no declared reference value. As Williamson himself is aware, a crucial assumption in his argument is that the parities to be defended are credible—something that was not always true under the Bretton Woods system.7

Just as important as the question of whether uncertainty is higher under flexible rates is the question of how costly any additional uncertainty might be. In principle, the cost of uncertainty might be measured by the price of purchasing insurance against it. In this regard, Johnson (1973, p. 213) invokes the economic principle that “… a competitive system will tend to provide any goods or services demanded, at a price that yields no more than a fair profit.” Similarly, most supporters of flexible rates, writing before the advent of generalized floating, predicted that floating would induce an expansion of facilities in forward exchange markets so that requests for insurance at most maturities could be handled efficiently. Writing in November 1974, McKinnon has shown, however, that such optimism about forward exchange markets has not been fully justified. In particular, McKinnon has documented that (i) bid-ask spreads in spot exchange markets have widened significantly from the 1960s, (ii) bid-ask spreads in forward markets8 have risen relatively more sharply—particularly in the longer-term contracts, and (iii) there has been no noticeable expansion in the facilities for forward trading across pairs of currencies, or in longer-term contracts. A recent study by Fieleke (1975) has similarly used data on foreign exchange (bid-ask) spreads as a proxy for the social cost of the services of foreign exchange traders. In brief, his empirical results support the proposition that these spreads vary positively with the degree of exchange rate variability.9

If the evidence suggests that the cost of purchasing protection against exchange risk has indeed risen, how much has this affected the price of traded goods? Probably very little. In markets for major currencies, the spread between bid and asked prices for forward exchange is rarely greater than 110 of 1 per cent of the transaction price.10 If it is borne in mind that the expected spot price is the midpoint of the spread, the cost added to price in each direction is therefore rarely greater than 120 of 1 per cent. Further, since hedging will also occur under an adjustable peg system, only part of these small cost figures represents the additional costs associated with flexible rates. Finally, any resultant increase in costs will be once and for all, and should therefore have no impact on the continuing rate of inflation.

This still leaves unanswered, however, the question of whether the effect of greater exchange rate variability in diminishing the quantity of international transactions will result in a significant interference with international specialization and thus a rise in unit costs. On the one hand, it could be argued that the cost of exchange rate uncertainty not covered in the forward market must be less than the price of insurance protection. Therefore, the effect of uninsured risks on the volume of transactions should be small. If, however, insurance protection is unavailable (Say, because of the institutional weakness of forward markets in certain currencies or maturities—e.g., see Witteveen (1975)), then more severe quantity effects on trade may result. This involves not only trade flows but direct and portfolio international investment as well. Suffice it to say that the only empirical studies now available on this issue relate to trade flows—hardly a surprising development, since any discernible effects on plant location decisions and the like are apt to be of longer-term nature. There seems to be no evidence that the volume of international trade has been adversely affected by exchange rate variability.11 For example, to quote Whitman (1975, p. 143): “Despite substantial fluctuations in exchange rates, the widely feared decline in international trade and investment has failed to materialize.” However, before-and-after comparisons of trade flows are not likely to be reliable for testing the independent effect of exchange rate uncertainty on international trade. What one really wants to know is whether flexible rates altered the volume of international trade relative to what it would have been under fixed rates, other things held equal. To answer this question, it is obviously necessary to control for other factors (besides exchange rate uncertainty) that are known to affect exports and imports, and to find an adequate proxy for exchange rate uncertainty. The study that probably comes closest to meeting at least the first of these two requirements is the recent paper by Makin (1974). He estimates import equations for the Federal Republic of Germany, Canada, Japan, and the United Kingdom on quarterly data for the period 1960–73. The explanatory variables used were real income, capacity utilization, relative import prices, and two alternative measures of exchange rate variability (one for the spot market and one for the forward market). The results suggested no statistically significant effect of exchange rate variability on real import demand in any of the four countries studied.12 It is perhaps fair to note that the substantial decline in world trade that occurred in 1974–75 has yet to be included and analyzed in empirical studies of the type just described.

In sum, it would seem that the impact of exchange rate uncertainty on the prices of traded goods and on the volume of international trade is likely to be so small that any contribution to inflationary pressures generated by flexible rates via this mechanism can probably be largely ignored. At any event, it should be taken into account only if the other advantages and disadvantages of the alternative regimes are finely balanced.

effects on the demand for liquidity

In addition to any effect on the demand for and supply of tradable goods, the nature of the exchange rate regime could also affect the world price level through its effect on the demand for liquidity (both official and private). Since in a general equilibrium framework the demand for real goods is the opposite side of the coin to the demand for money (or financial assets), the exchange rate regime will affect the former if it affects the latter.13

Both national monetary authorities and the private sector could conceivably be affected in their portfolio decisions by a change in the exchange rate regime. Governments may find a reduced need for currency reserves in a floating system where adjustment to balance of payments disequilibrium can take place to a greater extent through changes in the exchange rate. Similarly, the private sector may choose to hold smaller (larger) money balances because of the lower degree of certainty with which balances in any one currency can be converted into another currency under a flexible exchange rate regime. We shall consider each of these arguments in turn.

The traditional argument that the demand for international liquidity by monetary authorities will be reduced by a transition to flexible exchange rates runs as follows: Under flexible rates, the supply and demand for foreign currencies can be equilibrated via movements in the exchange rate; therefore, there will be less need for government authorities to hold foreign exchange reserves. Consequently, governments that hold such reserves (after the introduction of floating) will seek to run down this unproductive use of the national patrimony by having overall deficits in their balance of payments.14 Since one country’s deficit is another’s surplus, there will be an inconsistency in policy objectives, and the general attempt to reduce these excess reserve holdings will result only in an increase in prices.

Not all observers, however, would agree that this need necessarily be so. Williamson (1974), for example, has argued that if an exchange rate parity provides a credible estimate of the equilibrium exchange rate, the abandonment of the parity may lead to increased reserve use.15 This is so because, if the foreign exchange market is unstable in the short run to medium run (i.e., if private participants have extrapolative expectations concerning rate movements, and act on them), a movement to greater flexibility in exchange rates could conceivably lead to wider oscillations in exchange rates and to greater reserve use than would occur under a par value system. While Williamson’s argument cannot be dismissed out of hand, it represents in our view more the special case than the general one. Also, as Williamson himself notes, where the parity being defended is inappropriate (a not unusual occurrence in the latter years of the Bretton Woods system), the conclusion for reserve needs is reversed.

The available empirical evidence on reserve use under fixed versus floating rates is both limited and ambiguous. Williamson (1974), employing three alternative measures of reserve use, found no evidence of a decline in reserve use during the period of generalized floating vis-à-vis periods of fixed rates. In fact, a majority of the countries in his sample actually displayed an increase in reserve use under floating rates. Subsequently, Williamson’s results have been both updated (through 1975) and/or recalculated for some alternative definitions of reserve use by Ishiyama (1976) and Suss (1976)—and their results run counter to Williamson’s findings, that is, they lend support to the a priori expectation that reserve use would decline under increased exchange rate flexibility.16 In interpreting this evidence, one should note that none of the foregoing studies is able to develop a fully satisfactory method for estimating the independent effect of either increased exchange rate flexibility or generalized floating on reserve use. To do so, it would be necessary to hold constant all other factors affecting reserve use so that the separate effect of exchange rate flexibility could be identified. This is of course easier said than done but in principle it is likely to be better accomplished, or at least better approximated, within the context of a multiple regression model for reserve use than by simple before-and-after comparisons. The latter nevertheless will still be useful for indicating what happened to reserve use after generalized floating even if they do not provide information on why it happened.

If it is accepted that a transition to flexible exchange rates is likely, ceteris paribus, to lead to some reduction in reserve needs, to what extent is this likely to contribute to inflation? The answer depends of course primarily on how large the reduced demand for international reserves is—as well as on, inter alia, how much of the excess supply of reserves translates itself into an excess demand for goods and, in turn, how responsive inflation is to changes in the level of excess demand. While, as mentioned earlier, there does not as yet seem to be a reliable estimate of the impact of floating on the demand for international reserves, several empirical studies do exist on the relationship between changes in world reserves and changes in the world price level. More specifically, Keran (1975) has estimated a reduced form equation that relates changes in the prices of internationally traded goods (as measured by export prices of developed countries) to current and lagged changes in international reserves (of the developed countries). For the period 1962 to 1974, Keran found that an increase of 1 per cent in world reserves leads over a three-year period to an increase of approximately 1 per cent in world prices. Heller (1976) has also estimated the relationship between world reserves (as well as world money stock) and world (consumer) prices using a larger group of countries. In his equations using annual data for the period 1955–74, he found that an increase of 10 per cent in world reserves leads, after 2½ to 4½ years, to an increase of about 5 per cent in world prices. In interpreting the results of these studies, one should note that no explicit account is taken (at least in the equations) of other possible determinants of world inflation (such as supply factors or inflationary expectations). To the extent that these “omitted” variables are correlated with reserve changes, the resultant estimates of the elasticity of world prices with respect to world reserves may well be biased. This is not to say that the estimated relationship between world prices and world reserves is illusory, but rather to suggest that at this time we cannot be very confident about its magnitude.

In a related context, the inflationary consequences of an excess supply of world reserves need not be perfectly analogous to those arising from excess monetary creation in a closed banking system. In fact, in our view the former is apt to be less serious than the latter for at least two reasons. First of all, monetary authorities having excess reserve holdings are unlikely to run them down quickly (as might an individual with excess real balances), if only because (relative to individuals) they will be more fearful of setting in train a domestic inflationary spiral. This would at least suggest that the speed of adjustment, if not the long-run effect, will be lower for international reserves. Second, since the greater portion of world reserves forms the liabilities of another country (“inside” money in the domestic monetary analogue), holdings in excess of demand can be liquidated without necessarily giving rise to expenditures on real goods and services. In other words, the world supply of international reserves is an endogenous variable that can adjust at least in part so as to accommodate shifts in the demand for reserves. It is quite possible, for example, for a country with excess reserves to liquidate some of its excess holdings without increasing the reserves of any other country, thereby realizing a fall in the world stock of reserves.

Turning to the effect of the exchange rate regime on the private sector’s demand for money, it can be argued that increased exchange rate variability implies a reduction in the range of transactions for which balances in a given national currency act as an optimum store of value. For this reason, one might expect a transition to floating rates to induce a fall in the desire of private wealth holders to hold the traditional vehicle currencies. The implications of a move out of traditional vehicle currencies for world-wide inflation are far from clear, however. This is so because a decline in the usefulness of a single vehicle currency (or group of them) probably has its counterpart in an increase in the incentive to hold a diversified portfolio of currencies. If a private asset holder (e.g., a multinational corporation) has to hold balances in several currencies to meet fluctuations in payments and receipts in each currency separately, then it is likely that the total size of liquid balances will be greater than if all transactions were centralized in a single account. The intellectual pedigree of this proposition is in the Baumol-Tobin portfolio literature (including the so-called square-root law of money holdings), but at an intuitive level all that is being suggested is that flexible rates may lessen the economies in liquidity holding that can come from pooling liquid funds in a single currency of denomination.17

To the extent that the diseconomies-of-scale effect predominates over the substitution effect out of all currencies, then the private demand for money should, ceteris paribus, shift upward after a transition to floating, thereby decreasing the real demand for goods at a given level of the world money supply. On empirical grounds, however, we know of no evidence, one way or the other, on this potential consequence of floating. In particular, we are unaware of any empirical studies that attempt to account for exchange rate risk or uncertainty in the private demand for money.18 Further, it is our suspicion that it would be difficult to estimate the independent effect of the 1973 transition to generalized floating on the private demand for money. For one thing, the existence of active Euro-currency markets meant that there was probably sufficient flexibility in currency supplies to adapt to the kinds of demand shifts that a change in exchange rate regime might precipitate. Similarly, the possibility that monetary authorities might allow the supply of money to accommodate to shifts in the demand for it must be recognized, especially in a world where the authorities have at least half an eye to interest rate targets. Therefore, the task of identifying demand shifts from supply shifts is apt to prove troublesome for econometric work on this issue.

On balance, it seems reasonable to conclude that the net direct effects of the exchange rate regime on the price level are likely to be small. As to their direction, the arguments relating to the cost of exchange rate uncertainty and to the effects of exchange rate flexibility on demand for reserves point perhaps to some relative upward bias for flexible rates. We would readily concede, however, that the evidence here, be it theoretical or empirical, is sufficiently ambiguous that such a conclusion can be regarded only as tentative. Furthermore, the point made earlier must be recalled, namely, that effects on the price level of a change in exchange rate regime are once and for all, and therefore affect inflation only in the transitional period following the move from one regime to another. With this in mind, we can now proceed to examine the probable effects, if any, of the exchange rate regime on the continuing rate of world inflation.

II. Effects of the Exchange Rate Regime on the Rate of Inflation

As stated earlier, the exchange rate regime can affect the rate of inflation, either by changing the nature of the perceived trade-off between inflation and other policy objectives, or by changing the government’s relative preference for its various policy objectives. In what follows, we consider first how the exchange rate regime is likely to affect price pressures at a given level of aggregate demand. Next, we turn to the question of how exchange arrangements may affect governments’ demand management policies by influencing the way in which balance of payments equilibrium enters into the government’s set of policy objectives.

effects on policy possibilities—ratchet effects

Exchange rate changes, by themselves, generate equal and offsetting pressures on costs and demand in appreciating and depreciating countries, respectively. However, if prices react asymmetrically to positive versus negative changes in costs or demand, then exchange rate movements can have a net effect on the world price level. And if one exchange rate regime leads systematically to larger or more frequent changes in exchange rates, then there will be an effect on the overall trend of world inflation.

The existence of such an asymmetry is the basic premise of the so-called ratchet and asymmetries argument. As it is generally interpreted, this argument holds that flexible exchange rates have a global inflationary bias compared with fixed rates. This inflationary bias is said to arise because flexible rates imply more frequent exchange rate changes than do fixed rates, and because in a world of downward price inflexibility, devaluations lead to domestic price increases in devaluing countries that are greater than the corresponding price declines in revaluing countries. Thus, in contrast to a world where prices were equally flexible in both directions, and in which, therefore, exchange rate changes would be neutral with respect to the world price level, downward price inflexibility is said to ensure that each exchange rate change will “ratchet” the world price level to a new higher level. This reasoning implies that flexible rates will also produce an inflationary bias for individual countries over time (even if the mean value of the exchange rate remains unchanged), since domestic prices will be raised more by depreciations than they will be decreased by appreciations of the same size. As a general proposition, the ratchet argument implies that the more the exchange rate fluctuates in a positive/negative fashion (for any given mean value of the exchange rate), the more serious will be the inflationary ratchet effect.

The novel aspect of the ratchet argument lies not in the fact that it foresees price increases in devaluing countries19 but rather that it fails to predict equivalent price declines in appreciating countries.

Perhaps the best-known recent statement of the ratchet hypothesis is that (apparently) put forward by Professors Laffer and Mundell and interpreted by Wanniski (1974).20 Laffer and Mundell begin from the assumption that in an integrated world economy, arbitrage of goods will ensure both that the real price of tradable goods (i.e., the price of one good relative to another) is the same in all markets, and that the “law of one price” holds true. In aggregate terms, the law of one price merely posits that the domestic price level will be equal to the foreign (world) price level times the exchange rate (that is, Pd = Pf · e). Clearly, if this relationship governs the price of tradable goods in different countries, the effect of exchange rate changes on relative price levels of tradable goods will be immediately offset. However, by itself, this proposition says nothing about which price level will do the adjusting. Laffer and Mundell assume that it will be the price level in the devaluing country that bears the full burden of the adjustment, and that producers in devaluing countries will quickly raise their prices to the full extent of the devaluation.

Ultimately, the Laffer-Mundell ratchet hypothesis is a question of the size of both demand and supply elasticities and marginal spending propensities for traded (and nontraded) goods in the devaluing country relative to those in the revaluing country or countries. As long, however, as the size of these parameters is not very different in the two countries, both the devaluing and revaluing country will share the price adjustment to an exchange rate change.21 That is, both domestic (Pd) and foreign supply prices (Pf) will change (in opposite directions) by less than the amount of the exchange rate change (ė). Further, as long as the absolute value of the price elasticity of demand for imports is small relative to the supply elasticity for imports,22 one would expect import prices (in local currency) to fall somewhat in the revaluing country.23

The Laffer-Mundell hypothesis also carries the empirical implication that declines in the domestic currency price of imports should occur infrequently, if at all. Pigott, Sweeney, and Willett (1975) have documented, however, that such declines occurred in about 35 per cent of the quarters during the period 1957–74 (for the United States, the United Kingdom, Canada, Japan, the Federal Republic of Germany, and France, taken together). Some empirical evidence on export (supplier) price behavior after tariff reductions also casts doubt on the assumption of complete offsetting. For example, in a study of (foreign) export price behavior toward the U. S. market during the 1950s, Kreinin (1961, p. 317) concluded that “it appears plausible that close to half of the benefit from tariff concessions granted by the United States accrued to foreign exporters in the form of increased export prices.” Thus, while it may be quite likely that import prices would fall less after a revaluation than they would rise after a comparable devaluation, it seems unlikely that revaluation would produce no decline at all in import prices. The weaker statement, that exchange rate changes will likely impart some upward bias to the average level of the prices of traded goods, therefore seems more appropriate.

An alternative explanation for the ratchet effect focuses not on the asymmetrical effects of exchange rate changes on the prices of traded goods but rather on the asymmetrical effect of changes in the prices of traded goods on domestic prices (i.e., it focuses on downward price rigidities within national economies rather than at the level of international trade). One reason why changes in import prices might have an asymmetrical effect on final product changes is that there are costs to changing prices in imperfectly competitive markets,24 and that firms will change their prices only in response to those cost and demand changes that they view as permanent. To obtain the ratchet or asymmetry conclusion, it is then only necessary to assume that negative import price changes are viewed as more temporary than are positive changes.

There are several reasons for questioning the foregoing asymmetry argument. First of all, the distinction expected in theory is that between permanent and temporary changes, which will not necessarily coincide with that between positive and negative ones. Second, negative changes in import prices (expressed in domestic currency) have occurred too frequently in the postwar period—Pigott, Sweeney, and Willett (1975)—to be regarded as unusual events. Third, an asymmetry in pricing behavior as between positive and negative cost changes has the disturbing long-run implication that, ceteris paribus, profit rates would rise continually over time, since firms would be fully passing forward cost increases but would not be passing on cost decreases. One way around this difficulty is to interpret the ratchet argument as denoting an asymmetry in the time response of prices to positive versus negative cost changes. In other words, instead of assuming that the elasticity of price with respect to positive cost (or demand) changes is greater than that for negative changes, it could be assumed instead that the speed of adjustment of the actual price to the desired price is faster for positive than for negative import price changes. In this latter case, the short-run price elasticity would depend on the direction of the import price change but the long-run (or equilibrium) price elasticity would not. Unfortunately, there is not (to our knowledge) any empirical evidence available that would help in determining whether such an asymmetry in timing responses is of any practical concern. Finally, it is by no means clear on empirical grounds that producers do in fact change prices only in response to permanent cost or demand changes. Some empirical studies on pricing behavior (e.g., Nordhaus and Godley (1972)) support such a hypothesis, while others do not (Gordon (1975)).

In addition to asymmetries on the supply side, there can also be a ratchet effect generated by shifts in demand. This possibility has been noted by Witteveen (1975, pp. 113–14) who put the argument as follows:

Exchange rates influence the distribution of demand between domestic and foreign products, and rate fluctuations will involve demand shifts which will later in some measure be reversed. These demand shifts may well exert a ratchet effect on inflation. … shifts in purchase patterns brought about by the exchange rate changes, or even the expectation of such shifts, may tend to raise prices in the countries of depreciating currency without effecting a corresponding price reduction in the countries of appreciating currency.

Witteveen’s suggestion is essentially a restatement of Schultze’s (1959) concept of “demand shift inflation,” in an international setting. In brief, the central idea is that it is possible for inflation to be generated by shifts in the sectoral composition of demand, even if the level of aggregate demand remains constant, since prices will rise in those sectors where demand is increasing by more than they will fall in those sectors where demand is declining. One of the proximate consequences of an exchange rate shift will be to change the relative price of tradable and nontradable goods. The more pronounced and frequent are exchange rate changes, the more significant will be these intersectoral demand shifts and therefore the more serious will be the inflationary ratchet effect.

Evaluation of the Witteveen hypothesis is severely hampered by the absence of empirical work on demand asymmetries in industry price behavior.25 Not only have few empirical studies been done on the effect of positive versus negative changes in demand on industry price changes but those that do exist (e.g., Schultze (1959), Schultze and Tryon (1965)) relate almost entirely to manufacturing industries and therefore provide little information on pricing behavior for nontradables. To the extent that the ability to resist price cuts when demand falls is an indication of market power, there is probably a better a priori case for expecting such price behavior in nontradables, since these products are, by definition, not subject to international competition.26 Further, the fact that the share of services in gross national product has been rising steadily in most advanced industrial nations, despite the fact that the relative price of services has been rising at the same time, suggests that the price elasticity of demand for services (nontradables) is low, and/or that the income elasticity is quite high. On the other hand, as a general proposition, excess market power, even if it existed in nontradables, should have more to do with determining the level of prices (or the relative price of nontradables) than with the rate of inflation.

Some more general empirical evidence on the combined effect of these various (positive/negative) ratchet hypotheses is provided in a recent study by Goldstein (1976). Using alternatively the GDP deflator and the consumer price index as dependent variables, and employing a wide variety of alternative inflation models, specific asymmetry tests were conducted for five countries—the United States, the United Kingdom, the Federal Republic of Germany, Italy, and Japan—over the period 1958–73. In brief, the results point to the presence of an asymmetry between the effects of positive and negative import price changes on domestic price changes for Italy and Japan but not for the Federal Republic of Germany and the United Kingdom. The results for the United States are too ambiguous to support a definite conclusion. Further, even for those countries where there is some evidence of an asymmetry, the results are quite sensitive to the choice of sample period, the level of aggregation, and the particular inflation model used.

Moving from the direction of the exchange rate change to its size, the argument has been advanced that large changes in exchange rates (and hence in import prices) will have a greater proportionate effect on domestic prices than will small exchange rate changes. Again, the implicit notion behind this propostion is that there are costs associated with changing prices and that producers respond to these costs by changing prices only when cost or demand changes are viewed as large and permanent.27 Following Nordhaus (1972), stable prices can also be viewed as a service that producers offer their customers in order to obtain a larger share of the market.

It is immediately apparent that if the large/small ratchet effect is to impart an inflationary bias to one exchange rate regime compared with another, it is necessary (but not sufficient) to demonstrate that there is a difference in the size of the rate movements between the two regimes. It is obviously true that flexible exchange rates generate larger rate changes if fixed rates are permanently fixed. But if fixed exchange rates are interpreted as the adjustable peg system, then the conclusion could well be reversed. That is, flexible rates could be less inflationary, ceteris paribus, because the exchange rate movements necessary to equilibrate the balance of payments would come in small steps at frequent intervals rather than in large discrete jumps under conditions of fundamental disequilibrium. As mentioned earlier, in Section I, exchange rate changes have probably been larger under managed floating than they were at most times under the Bretton Woods system. However, these recent exchange rate movements obviously owe something to the increased uncertainties of the more recent past, uncertainties that are attributable to a variety of causes apart from the exchange rate regime. If there is any difference between the two systems in regard to the probable size of exchange rate changes, it is certainly not an obvious one.28

Even if it could be demonstrated, however, that one exchange rate regime produced larger exchange rate changes than the other, and even if a large/small ratchet effect did exist, this would not necessarily imply that larger exchange rate changes produce an inflationary bias for the world economy. The reason is that, in the absence of a positive/negative ratchet effect, the price consequences of a large downward movement in a bilateral exchange rate for one country will be offset by the large upward movement for the other. Thus, as far as the world inflation rates goes, it is the positive/negative ratchet that is important and not the large/small distinction.

Individual country inflation rates could of course still be affected by the presence of a large/small ratchet effect. At this point, however, there is no clear evidence that a ratchet effect related to the size of exchange rate changes exists. More specifically, the available empirical studies that have tested for large/small or “threshold” effects generally relate either to the labor market or to the demand for traded commodities, rather than to the relationship between import price changes and domestic price changes; furthermore, these studies relate for the most part only to the economy of the United States. For example, Hamermesh (1970), Eckstein and Brinner (1972), and Gordon (1972) have found some evidence for the United States that the money wage response to price changes is greater when inflation is high than when it is low. Sumner (1972) has obtained a similar finding for U. K. wage behavior, but Goldstein (1974) has obtained contrasting results. Spitäller (1975), also in a U. S. study, finds that the dependence of current inflation on past inflation rates rises when the inflation rate exceeds 4 per cent. Since exchange rate movements give rise to wage-price interactions,29 these studies lend some (indirect) support to the existence of a large/small ratchet effect. On the other hand, some other empirical tests of the large/small hypothesis in different but still related settings point to a contrasting conclusion. For example, Goldstein and Khan (1976 b) in a study of aggregate import demand of 12 industrial countries found no evidence that either the relative price elasticity of demand or the speed at which actual imports adjust to the desired level was related to the size of the relative price changes. Finally, Goldstein (1974), in a study of price behavior in the United Kingdom, found that large changes in import prices did not have a greater proportionate effect on retail prices than did small changes.

All things considered, the empirical evidence for the existence of ratchet effects, be they of the positive/negative or of the large/small variety, is not particularly compelling. Nevertheless, if these ratchets do exist—and the empirical evidence certainly does not preclude this possibility—the net price effects would seem to point in only one direction. That is, since no one suggests that negative import price changes will have a greater proportionate effect on domestic prices than positive changes, we are inclined to conclude that flexible rates (because of their greater propensity to induce positive/negative oscillations) are likely to contain some inflationary bias for the world economy. Having said this, however, we must immediately qualify it by noting that other welfare considerations may be important (Section III) and that the empirical evidence is not strong enough to put this consideration forward on more than a tentative basis.

effects on government’s policy choice

The exchange rate regime may influence a government’s choice of policy objectives in two main ways. The first results from the fact that any upward price bias imparted by the exchange rate regime will change the nature of the short-run inflation/unemployment trade-off confronting policy authorities, and thus will prompt a re-evaluation of policy targets. The second results from the fact that balance of payments equilibrium requires more active use of domestic policy instruments under fixed exchange rates than it does under a floating regime. These two influences are considered in turn.

If one exchange rate regime leads to higher prices at a given level of nominal demand (say, because of ratchet effects) it will lead to lower real income and, hence, will tend to generate an increase in unemployment. If the policy authorities attach high importance to maintaining a given rate of unemployment, they may react to the deflationary effect of rising prices by providing for an increase in nominal demand. This hypothesis has been put forward by Shields, Tower, and Willett (1974), among others. To illustrate this point, Shields and others consider the case of a country that revalues when there is no excess demand in the tradable goods sector. Assuming the usual substitution effects in consumption and production, the revaluation should lead to a fall in output and employment in the export and import competing sectors (of the revaluing country). Faced with this situation, the authorities may well react by increasing the money supply and aggregate demand so as to prevent any increase in unemployment. The result of such an expansionary policy will be an exacerbation of inflationary pressures.30 In this policy scenario, it is not structural factors but rather the unwillingness of the government to accept any increase in unemployment above its target rate that allows revaluation to be inflationary.

More generally, if one accepts the assumption that the government will expand aggregate demand whenever there is a prospective increase in unemployment above the target rate, any factor that tends to worsen the inflation/unemployment trade-off will cause the government to respond in such a way as to increase the rate of inflation.31 Thus, to some observers (e.g., Kenen (1974)), the analysis of Shields and others provides just a further illustration of how the politics of full employment can generate inflation when all other factors would or should drive prices downward. A second point of qualification is that unless one can identify what the government’s target unemployment rate is, the foregoing hypothesis will be of limited value in predicting the demand-management response to a revaluation. This in turn is apt to be quite difficult to do, since the target rate may change quite markedly over a short period. In this connection, one could interpret the unusually high unemployment rates of 1974 and 1975 in most industrial countries as suggesting that these countries have shifted upward their definitions of the target unemployment rate. In any case, the recent unemployment experience does seem to suggest that governments do not automatically increase aggregate demand in response to every prospective increase in unemployment, be it revalution-induced or otherwise.

The second, and perhaps more important, way in which the exchange rate regime may affect inflation is through the different constraints that alternative regimes introduce on governments’ freedom of policy choice. This argument is usually referred to as the “discipline argument” and has long been prominent in the debate on fixed versus flexible rates. Indeed, even such supporters of flexible rates as Sohmen (1963), Haberler (1964), and Yeager (1968) view it as perhaps the most potent objection to a system of flexible rates.32

The reserve discipline hypothesis can be stated as follows: Under fixed exchange rates, a country that inflates at a rate higher than that of its trading partners will, ceteris paribus, suffer a deterioration in its balance of payments and a loss of international reserves. As long as there is an inhibition about using the exchange rate to restore equilibrium in the foreign exchange market, the high-inflation country will ultimately have to discipline itself by restraining aggregate demand so as to bring its inflation rate into line with that of its trading partners. Implicit here is the notion that the fixed exchange rate and the declining reserve stock provide the rallying points necessary to convince the public in the high-inflation country to willingly accept the imposition of unpopular domestic restraints. (See, for example, IMF (1970).) By contrast, it is claimed that a much weaker discipline exists for surplus countries, since there is no equivalent constraint on the almost indefinite accumulation of reserves.

Under a flexible exchange rate regime, this asymmetry of reserve discipline is said to be absent. When rates are floating, the immediate consequence of a relatively high inflation rate is a depreciation of the currency concerned and, in turn, a higher nominal price level in the high-inflation country. As long as the familiar Marshall-Lerner conditions for exchange market stability are satisfied, a flexible exchange rate will equilibrate supply and demand in the foreign exchange market automatically, and hence will remove the balance of payments as a constraint upon domestic policy decisions for both surplus and deficit countries. Thus, the external pressures to reduce the inflation rate will disappear and, according to the discipline argument, inflation will be higher with flexible exchange rates than it would have been with fixed rates.

The validity of the reserve discipline hypothesis rests essentially on two propositions. The first is that a fixed exchange rate regime will reduce the dispersion of inflation rates across countries because, in contrast to a floating regime, it does not permit countries whose desired inflation rates are different from the world average to exercise these preferences. The second is that such dispersion is narrowed more by reducing the inflation rate of high-inflation countries than by increasing the rate of low-inflation countries. The evidence bearing on these propositions can be examined in turn.

To judge from the evidence currently available, the period since generalized floating began (early 1973) has indeed been accompanied by an increase in the dispersion of inflation rates across countries. Studies by Pigott, Sweeney, and Willett (1975), Teigen (1975), and Heller (1976) have documented that inflation rates, as measured both by consumer and wholesale price indices, have shown greater intercountry variation in the period 1973–75 than during most of the fixed rate period (e.g., 1960–70). Here again, however, one must be cautious about ascribing this increase in the dispersion of inflation rates to floating per se, both because the exchange rate regime is only one among several factors that can cause shifts in relative policy preferences about inflation, and because observed inflation rates also reflect other exogenous shocks.

Even if it is accepted that fixed rates reduce the dispersion of inflation across countries, this would not itself make them anti-inflationary unless the second proposition also held. Fixed rates tend to tie all countries to a common rate of inflation but, as Johnson (1973) has pointed out, there is no presumption that this rate should be high, low, moderate, or even positive. What then are the arguments for supposing that the reserve discipline works asymmetrically, and specifically that it works more strongly on high-inflation countries? It is certainly true that the transition to floating rates has been accompanied by high rates of price inflation, but it is much less clear whether this can be attributed to a loosening of policy restraints. As Witteveen (1975, pp. 112–13) has summarized:

… there is not much evidence that the transition to floating rates in 1973 has led to a perceptible loosening in demand management. The expansion in money stocks which laid the foundation for the boom took place from 1970 to 1972 which, despite an interlude of floating in 1971, was on the whole a period of fixed rates.33

Taking a somewhat longer historical perspective, it is possible to argue that the nature of the adjustment mechanism as it actually operated under the Bretton Woods system did in fact place a greater adjustment burden (discipline) on deficit than on surplus countries. This was due to the fact that deficit countries (at least those that were not reserve centers) were limited in their ability to resist adjustment because their reserve holdings were finite; surplus countries, on the other hand, could continue to accumulate reserves without sanctions other than those of the moral suasion variety. There has also been the tendency in political discussions of payments questions to equate balance of payments surpluses with good, and deficits with bad, economic management. Partly, this reflects a simple application of the economics of Mr. Micawber; in part, also, it has been buttressed in some countries by economic arguments based on the theory of export-led growth (Lamfalussy (1963) and Kaldor (1966)). But, whatever the reason, the political pressure has frequently fallen more heavily on countries suffering from balance of payments deficits and rapid inflation rates. Among major countries that have been led to adopt restrictive domestic policies for balance of payments reasons have been the United Kingdom (1954–55, 1957, 1960–61, 1965–66), Italy (1963–64), Japan (1956–57, 1963–64, 1966–67), and France (1956–57). Finally, during much of the Bretton Woods period the international monetary system was operating with a declining ratio of reserves to world trade; and in such an environment of limited liquidity, it could be argued that reserve pressure would operate most strongly on deficit countries.

Although the foregoing reserve discipline argument is often made, it has not gone unanswered. In the first place, it has been claimed that the nature of the adjustment process under the Bretton Woods system in practice imposed precious little discipline on deficit countries—and even that the main discipline was brought to bear on the surplus countries that wished to have lower than average inflation rates. Second, it has been suggested that flexible rates contain their own brand of anti-inflationary discipline, which may even be more effective than the discipline of reserve availability. We shall consider each of these points in turn.

From our earlier discussion, it follows that if reserve discipline were practiced only by surplus countries, or more strongly by them than by deficit countries, then, in a reversal of the conventional case, one would be led to the conclusion that fixed rates are likely to be more inflationary. To some observers this portrayal of the distribution of adjustment is a better description both of the past operation of the Bretton Woods system and of future prospects for fixed rates than is the alternative assumption that deficit countries will make the adjustments. In brief, the rationale for this position proceeds as follows.34 Because money wages and prices are inflexible (or at least sticky) in a downward direction and because modern governments are unwilling to tolerate the employment losses associated with deflationary policies, it is unrealistic to expect deficit countries to adopt the discipline of deflation. Rather, their response to reserve losses is more likely to take the form of devaluation or of direct controls on trade and payments. Therefore, if balance of payments equilibrium is to be re-established without altering exchange rates, it will be incumbent upon surplus countries to adopt expansionary policies such that their inflation rates increase vis-à-vis the deficit countries.

Clearly this view of how the Bretton Woods system operated is at variance with the one advanced earlier, and concerns essentially the interpretation of historical fact. We noted earlier several instances in which deficit countries were led to restrain domestic demand in the interests of balance of payments equilibrium. On other occasions, however (the United States is the most prominent but not the only example), deficit countries were enabled to maintain their exchange rates without domestic measures, by running down reserves or borrowing abroad. Furthermore, particularly in the later years of the Bretton Woods system, many countries chose devaluation rather than trying to maintain their existing exchange rates through changes in domestic policies. Turning to the case of surplus countries, there is also something to be said on both sides of the argument. The Federal Republic of Germany probably felt during much of the 1960s that it was being required to have more domestic inflation than was desirable as the price of maintaining a fixed exchange rate; but nevertheless it was still able to run a considerable surplus on its balance of payments during this period. France, during the period 1960–66, and Sweden, during the period 1950–66, also provide examples where demand-management policy was not adjusted to counter balance of payments surpluses.

All in all, the Bretton Woods experience is probably best viewed as providing qualified support for the argument that balance of payments deficits are likely to prompt stronger demand-management adjustment measures than are comparable surpluses. This conclusion is essentially the one reached by Michaely (1971, pp. 63–64) in an empirical study of the responsiveness of demand policies to balance of payments developments in nine industrial countries over the period 1950–66: 35

Countries whose monetary policy generally responds to changes in the balance of payments tend to make exceptions to this pattern of behavior mainly when they are in surplus. Similarly, compliance of monetary policy with balance-of-payments requirements in generally noncomplying countries tends to be found at times of deficits. … It also appears that this tendency is not necessarily related to the level of external reserves. … It seems that countries tend to regard as their external target not so much the attainment of balance-of-payments equilibrium as the avoidance of deficits. … The loss of reserves is viewed with concern; but their accumulation … is viewed, in fact, with satisfaction or indifference.

Whatever asymmetries in reserve discipline are felt to have existed in the past, it is important to note that the same biases need not exist in any future fixed rate system. The asymmetries in the sharing of the adjustment burden under the Bretton Woods system were essentially the result of a malfunctioning of that system, and international monetary authorities are now well aware of them. It is accepted that in any future par value system, care should be taken to ensure that adjustment pressures fall equally on deficit and surplus countries.

In order for the discipline argument to yield an inflationary bias in a fixed exchange rate system, it is necessary not only that there be asymmetric pressures on surplus and deficit countries but also that these asymmetries have a stronger anti-inflationary bias when rates are fixed than when they are floating. This latter proposition has been questioned by Emminger (1973).36 Emminger points out that under a par value system the only immediate consequence of a high-inflation policy is a rundown of the stock of reserves of the country concerned. Under flexible rates, however, such behavior will result in a depreciation of the exchange rate, and, in turn, an increase in domestic prices in the high-inflation country. Thus, the cost of a high-inflation policy—the declining purchasing power of domestic incomes over foreign goods—will be more easily and quickly noticed by the public under flexible rates. Assuming that inflation is unpopular, and that the government is responsive to public opinion, the foregoing implies in turn that inflationary policies will be more quickly restricted under flexible rates than when there is the option of financing them by reserve depletion, as under fixed rates.

Once one admits, however, the reasonable possibility that the high-inflation country will ultimately have to devalue (if the fixed rate system is of the adjustable peg variety), then the issue simply reduces to one of whether a given increase in inflation now will have a greater disciplinary effect than the perceived cost of a devaluation later. Furthermore, even if policy makers are influenced by a desire to avoid inflation now, it is still not clear that flexible rates are asymmetrical in their inducements to adjust. Under flexible rates, countries may be equally keen to avoid deflationary policies that cause their exchange rates to appreciate, because the safety valve of exports will not be available to take up slack in employment when domestic demand is inadequate.

The conclusion to be drawn is that flexible rates tend to magnify the domestic consequences of policy mistakes; but it is not clear why the authorities should be more concerned with inflationary than deflationary mistakes, as would have to be true for flexible rates to generate an anti-inflationary bias.37

In summary, we find that there are quite good arguments on both sides of the reserve discipline issue. On the whole, however, it seems to us that there is more reason to expect anti-inflationary discipline to be practiced by deficit countries under fixed exchange rates than when rates are floating—unless, of course, the exchange rate system includes some (new) additional feature designed to promote balance of payments adjustment by surplus countries. Again, however, such a conclusion is tentative and does not touch on the welfare implications of reducing the dispersion of inflation rates across countries—a point about which more is said in the concluding section.

III. Conclusions

This paper has addressed the question, “Are flexible exchange rates more inflationary than a system of fixed exchange rates?” Not surprisingly, the answer is, “It all depends,” and in the preceding two sections we have sought to identify and evaluate the more important factors that bear on the issue. Yet despite the numerous arguments and counterarguments from one exchange rate system to the other and despite the importance attached to this issue in discussions concerning international monetary reform, we find it hard to escape the overall conclusion that the type of exchange rate system has relatively little influence on the average rate of world inflation. Having said this, there does appear to us to be a case—resting more on a priori plausibility and past experience than on strong empirical evidence—for supposing that flexible exchange rates make it easier for inflationary pressures to arise and to be accommodated than do fixed rates. In a world in which prices have become less flexible over time in both directions, but especially so in a downward direction,38 the notion that devaluations (depreciations) will produce a larger proportionate effect on domestic prices than will revaluations (appreciations) of the same size carries a certain intuitive appeal. Similarly, it seems to us easier to find examples under fixed rates of the (reserve) discipline effect working to restrain demand than the reverse. But we would concede in all of this that our conclusion is tentative and that other observers might interpret past history differently.

Even if, however, it could be demonstrated that one exchange rate system was less inflationary than the other, this would not necessarily imply that there would be a clear welfare advantage in choosing the less inflationary system for at least two reasons. In the first place, the exchange rate regime has implications for the dispersion of individual country inflation rates about the world mean. If there is considered to be an advantage in permitting countries to follow their own preferences concerning inflation and unemployment targets, then there are clearly costs involved in constraining countries toward a common inflation rate as a fixed exchange rate regime implies.39 Thus, the “discipline of conformity” required in a fixed exchange rate regime should be regarded, in our view, as a cost to be set against any benefits associated with fixed rates, including the possibility of a lower average rate of world inflation. Further, the extent of this cost will depend on how widely dispersed countries’ preferences concerning the desired rate of inflation are about the world average. Second, most of the costs traditionally associated with inflation (for example, the misallocation of resources, the redistribution of income and wealth) relate for the most part to unanticipated inflation. A perfectly foreseen inflation will presumably be discounted in all contracts relating to the future, and the only welfare loss associated with it should be the wasteful use of resources to economize on holdings of currency and of other noninterest-bearing means of payment. (See, for example, Tobin (1972).) To argue therefore that a lower average rate of world inflation represents a clear welfare gain is to imply that the average amount of unanticipated inflation will fall with it. While there is mounting historical evidence (e.g., see Okun (1971), Logue and Willett (1976)) that higher mean rates of inflation are associated with greater variance (instability) in inflation rates (across countries), the strength of this relationship and the explanation for it remain sufficiently cloudy (Gordon (1971)) to preclude drawing definite welfare implications.

Several other relationships between inflation and the exchange rate regime are also worth repeating. First, from the viewpoint of an individual country, the exchange rate regime may well influence how much inflation it generates, transmits, or receives. For example, if a country’s desired inflation rate is higher (lower) than the actual inflation rate prevailing in the rest of the world, one would expect, ceteris paribus, that country’s actual inflation rate to be lower (higher) under fixed (flexible) rates. Similarly, if the source of a country’s inflationary disturbances are typically of external (domestic) origin, then, ceteris paribus, one would expect flexible (fixed) rates to be less inflationary. Second, in considering the transition from one exchange rate regime to another, say, that from fixed to flexible rates, one might expect the exchange rate regime to have a once and for all effect on the world price level. For example, if flexible rates are associated with both a higher uncertainty cost (for producers and consumers) and a lower demand for international reserves, than a move from fixed to flexible rates is apt to cause a once and for all upward jump in the world price level. Finally, while we have concentrated here on the effect of alternative exchange rate systems on the rate of inflation, the dominant line of causation probably runs the other way. That is, as events of recent years have dramatically demonstrated, where inflation is high, variable, and different across countries, it may well be the exchange rate regime that adjusts before the rate of inflation.

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*

Mr. Crockett, Chief of the Special Studies Division of the Research Department, is a graduate of the University of Cambridge and of Yale University.

Mr. Goldstein, economist in the Special Studies Division, is a graduate of Rutgers University and of New York University. He was formerly a Research Fellow in Economics at the Brookings Institution.

1

For a good treatment of the transmission mechanism, see Swoboda (1974) and Sweeney and Willett (1974).

2

This is not to say that flexible rates will insulate a country from all types of external disturbance; see, for example, Cooper (1976).

3

The obvious analogy here is with the (graphical) analysis of consumer demand, where equilibrium quantities are determined at the tangency of the indifference curve and the budget line.

4

We recognize that considerable doubt exists in the theoretical literature (Friedman (1968) and Phelps (1968)), and to a similar extent in the empirical literature (Goldstein (1972), Laidler and Parkin (1975), and Rutledge (1975)) about whether there is any long-run or “permanent” trade-off between inflation and unemployment. For the purposes of this paper, however, all that is necessary is that governments act as if they believed that such a trade-off exists, at least in the short run.

5

However, even when forward cover is available, it will not provide complete protection for the buyer against exchange risk unless he is able to forecast at the time of making the forward contract how much foreign exchange he will need and the date on which he will require it. This point is attributable to Clark (1973).

6

In support of this argument, it is said that in a free floating system destabilizing speculators will tend to lose money and thus will ultimately be driven out of business. (See Friedman (1953).)

7

Although, in a better-managed par value system, it is reasonable to hope that officially established exchange rates would be more credible than those in effect under the last years of the Bretton Woods system.

8

The bid-ask spread is the appropriate measure of the social cost of forward cover, not the gross premium or discount. This is so because the bid-ask spread measures the cost of purchasing insurance against the possibility of the actual rate diverging from the expected rate (which may be regarded as the mean of bid and asked quotations).

9

Grubel (1966) has also pointed out that under flexible rates more trade will be covered through the forward market, where spreads are higher, than in the spot market and that this factor will contribute to the relatively high cost of flexible rates. McKinnon (1974) has reported, however, that much of the increase in the demand for forward cover expected under flexible rates seems to have been shifted to the spot market. In other words, firms that want to hedge seem to be buying (selling) foreign currencies ahead of their needs and just holding them spot—something that also involves costs, as it ties up liquid assets.

11

It should be borne in mind here that any increase in the volume of international trade need not represent an unambiguous improvement in world welfare. In this regard, McKinnon (1974) has brought up the issue of “false trading”—by which he means the international movement of goods according to transitory price/cost relationships that do not accurately reflect long-run comparative advantage. If floating contributes to such false trading, before-and-after comparisons of trade flows become even more difficult to interpret in a welfare sense. See also Lanyi (1969) on the welfare aspects of the amount of international trade and the government’s role in “subsidizing” trade under fixed exchange rates.

12

Clark and Haulk (1972) also examined the effect of exchange rate variability on Canadian trade flows (using a methodology similar to Makin’s) and obtained the same general conclusions as Makin (1974).

13

In a world where money and goods were the only two assets, Walras’s law would insure that the excess demand for goods equaled the excess supply of money. The classic empirical application of this relationship is that of Cagan (1956). When other financial assets (equities) are admitted, the relationship between excess demand in the money market and the rate of inflation is less direct; see, for example, Mussa (1975).

14

See Fleming (1975) for a more extensive discussion of reserve use under managed floating.

15

The view that the need for reserves will be just as great (or, perhaps, even greater) under flexible rates as under fixed rates had also been put forth earlier by Harrod (1965), pp. 44–45.

16

In addition, there is a considerable empirical literature that suggests that, ceteris paribus, the demand for reserves will vary positively with the variability of trade or of payments imbalances. (See Grubel (1971) and Williamson (1973) for reviews of these studies.) To the extent that floating reduces the size of this variability, it should reduce the demand for reserves.

17

For application of the square-root law to the demand for international liquidity, see Heller (1968), Olivera (1971), and Officer (1976).

18

Heller (1976) has argued that there was a general reduction in the world-wide demand for dollars in the early 1970s that was not uncorrelated with fears about the dollar as a long-run store of value. His study does not, however, attempt to estimate the effect of exchange rate flexibility per se on the private world demand for dollars or for other vehicle currencies.

19

For empirical work on the extent of devaluation effects on the domestic price level, see Goldstein (1974), Isard (1974), Kwack (1974), Nordhaus and Shoven (1974), Ball and others (1975), Jonson (1976), and Laffer (1975).

20

We say “apparently” put forward by Professors Laffer and Mundell because this ratchet argument does not, to our knowledge, appear in either Laffer’s or Mundell’s published work. Further, it is mentioned in only one of the two pieces, in (1974) but not in (1975), written by Wanniski that seek to summarize the Laffer and Mundell view of the world economy.

21

See Dornbusch (1975) for the exact expression showing how the country distribution of price changes after an exchange rate change is related to the relative sizes (between countries) of the marginal spending propensities on nontraded goods and of the compensated (excess) supply elasticities for traded goods.

22

Empirical estimates of demand and supply elasticities for exports and imports can be found in Magee (1974), Stern and others (1975), and Goldstein and Khan (1976 a and 1976 b).

23

See Branson (1972) for the expression showing how the elasticity of the import price (in domestic currency) with respect to an exchange rate change is related to the relative size of the demand and supply (price) elasticities for imports.

24

For a discussion of these costs, both direct (e.g., information, bookkeeping, printing) and indirect (e.g., danger of upsetting price harmony), see Nordhaus (1972) and Scherer (1973). Also, in imperfectly competitive markets, firms can adjust to demand changes by altering inventories, order backlogs, and output, as well as by changing price; on this, see Hay (1970).

25

There are many empirical studies on the question of whether demand changes (independent of their effect on factor costs) are a significant determinant of industry price changes; for a review of this literature, see Nordhaus (1972) and de Menil (1974). Obviously, however, this is not the same as asking whether positive changes in demand have a different impact on prices than do negative changes.

26

Of course, as long as producers of nontradables are subject to sufficiently strong domestic competition, one would not expect them to be able to set prices independently of demand conditions.

27

For a clear statement of this argument as applied to price elasticities in international trade, see Orcutt (1950) and Liu (1954).

28

Katz (1972), for example, also seems to share the view that there is no a priori reason to expect the size of exchange rate movements to be significantly different between a par value system and a flexible rate system.

29

As a more general matter, the presence of a wage-price spiral magnifies whatever inflationary effect is produced from a ratchet effect operating on the price of traded goods. Indeed, it is sometimes argued that deficit countries can by this mechanism find themselves in a vicious circle of deficits and inflation. An initial deficit causes a depreciation in the exchange rate, which pushes up domestic prices thus provoking wage claims that accelerate the process of inflation. Although certain countries (Italy and the United Kingdom may be recent examples) have faced serious problems resulting from the wage-price spiral effect, it would be incorrect to say that this factor, by itself, can impart an inflationary bias to a flexible rate regime. The nature of the regime may affect the size of the inflationary disturbances; but it will affect the strength of the subsequent wage-price spiral only if there are threshold effects in wage and price determination.

30

Shields, Tower, and Willett (1974) also assume throughout their analysis that there is no factor mobility between the traded and nontraded goods sectors, and that money wages and prices are inflexible downward in both sectors.

31

The authors seem to be well aware of this. In fact, one of their central points is that under the assumptions typically employed to show that devaluation is inflationary, revaluation can also be shown to be inflationary.

32

For further discussion of the reserve discipline argument, see Phaup (1974).

33

Using data reported by Heller (1976) on the world money stock, it turns out that the annual increase in the world money stock averaged 12.8 per cent for the period 1970–72 versus 11.5 per cent for the years 1973 and 1974.

34

See, for example, Friedman (1953), Johnson (1973), and Haberler (1974 a; 1974 b).

35

The nine countries studied by Michaely (1971) were Belgium, France, the Federal Republic of Germany, Italy, Japan, the Netherlands, Sweden, the United Kingdom, and the United States. Michaely found that monetary policy was most closely adjusted to balance of payments conditions in the United Kingdom and Japan; less responsive to the balance of payments in France, Belgium, the Netherlands, and Italy; and least responsive in the United States, the Federal Republic of Germany, and Sweden.

36

Also, see Crockett and Nsouli (1975) for a presentation of this point of view.

37

If there is a nonlinearity in the relationship between the rate of inflation and the level of excess demand, then policy errors in one direction may be judged to be more serious than errors in the other direction. Such a nonlinearity would also imply that it would be more inflationary (for the world as a whole) to “bottle up” inflationary disturbances in one country (as under flexible rates) than to spread these disturbances around (as under fixed rates); see, for example, Fleming (1971) on this point.

38

Empirical support for this proposition, at least for the United States, can be found in Cagan (1974).

39

However, as long as there is no long-run trade-off between inflation and unemployment, there will be no permanent unemployment cost (or benefit) of being obliged (by fixed rates) to adhere to a common inflation rate. See, for example, De Grauwe (1975).